The repurchase agreement (which consists of the sale of a security and an agreement by say a bank to repurchase it later) will pro- vide funds for a short period of time, after which the bank buys back the security as previously agreed. Of course, an alternative to the repo is for the bank to borrow federal funds from a depository institution that holds excess reserves.

Thus, depository institutions view the repo market and the federal funds market as close substitutes.

Federal Funds Rate

The interest rate at which federal funds are bought (borrowed) by deposi- tory institutions that need these funds and sold (lent) by depository institu- tions that have excess federal funds is called the federal funds rate. The federal funds is a benchmark short-term interest. Indeed, other short-term interest rates (e.,g, Treasury bills) often move in tandem with movements in the federal funds rate. The rate most often cited for the federal funds market is known as the effective federal funds rate.

The daily effective federal funds rate is volume-weighted average of rates for federal fund trades arranged through the major New York bro- kers. To illustrate how this averaging is accomplished, suppose only two transactions took place on October 1, one for $50 million at a rate of 2.75% and another for $200 million at rate of 2.875%. The simple arith- metic average would be 2.8125% which is calculated as follows:

(2.75 + 2.875)/2

By contrast, the transaction-weighted average for that day would be 2.85% which is calculated as follows:

(50/250)(2.75) + (200/250)(02274.275257875\5557\0)\560

The weighted average exceeds the arithmetic average because the larger transaction occurred at the higher rate.

Exhibit 6.4 presents a Bloomberg screen that plots the daily effective federal funds rate over the 1-year period beginning October 31, 2000 and ending October 31, 2001.

When the Federal Reserve formulates and executes monetary policy, the federal funds rate is frequently a significant operating target. The Fed- eral Open Market Committee (FOMC) sets a target level for the federal funds rate. Announcements of changes in monetary policy specify the changes in the FOMCs target for this rate. For example, due to the slug- gish U.S. economy in 2000-2001 and the terrorist attacks on September 11, 2001, the FOMC launched a dramatic easing of monetary policy by lowering the target federal funds ten times through November 8, 2001. Exhibit 6.5 presents a Bloomberg screen of a time series plot of the target federal funds rate for the period December 31, 2000 through November